Consider the following data for the two geographical divisions of the Potomac Electric company that operate as profit centres:
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Atlantic Division
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Pacific Division
|
|
Total Assets
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$1,000,000
|
$5,000,000
|
|
Current Liabilities
|
250,000
|
1,500,000
|
|
Operating Income
|
200,000
|
750,000
|
Required:
1. Calculate the ROI for each division using operating income as the measure of income and total assets as the measure of investment.
2. Potomac Electric has used RI as a measure of management performance, the variable it wants a manager to maximize. Using this criterion, what is the RI for each division using operating income and total assets, if the required rate of return on investment is 12%?
3. Potomac Electric has two sources of funds: long-term debt with a market value of $3,500,000 and an interest rate of 10%, and equity capital with a market value of $3,500,000 at a cost of 14%. Potomac's income tax rate is 40%. Potomac applies the same weighted average cost of capital to both divisions because each division faces similar risks. Calculate the EVA for each division. Which of the measures calculated in requirements 1, 2 and 3 would you recommend Potomac Electric use? Why?
4. Using your answers in requirements 1, 2 and 3, what would you conclude about the performance of each division? Explain briefly.